Trading 101: Trading vs. Investing
A historic debate without a real purpose.
Those who deal with financial markets professionally more often than not can be put into one of two categories: Traders and Investors. The main difference in the approach of the two groups is time-frame that they focus on. Traders deal with short-term fluctuations in the market, while investors tend to focus on long-term returns, through holding positions for years.
This difference leads to a certain, mostly unnecessary, ideological stand-off between traders and investors. Several value focused players simply don’t except that consistent returns can be achieved through short-term trading, while traders often think that holding on to positions through bull markets and bear markets is a waste of resources and profits.
On an interesting note, some old-school economists ridicule both camps with the simple, yet powerful “rule” that it’s impossible to beat the market, as financial markets are perfect discounting mechanisms, and the returns of the likes of Warren Buffet or Stan Druckenmiller (and countless others) are the product of pure luck.
The two approaches have way more in common than most investors or traders realize. First and foremost, both camps use the assumption that you actually can achieve excess returns by analyzing financial markets and financial assets. This means that markets are not “perfect” and irrationality is common.
[ecko_annotated header=”Short-term vs. long-term” annotation=””]
Without going into academic details, this has everything to do with the psychology of groups, investors tendency to act emotionally (fear and greed…), and the huge size of some of the players (banks, pension funds, insurance companies, and other institutions) that brings the real world far from the perfect environment of economic models. When you learn to trade successfully or learn how to pick undervalued companies, you simply acquire skills that the masses don’t have, while taking advantage of the flexibility of being an individual investor with a relatively small amount of capital.
Another important similarity is the need for discipline. If you are a value investor and you have to be ready to buy stocks (or any other asset) in the time of crisis and market panic (when the there is blood on the street…). You also have to endure losses, should the market move against you; in fact, if you are confident in your analysis, you should buy more, as your choice of investment just got even cheaper. When trading, you will have to be able to take small losses and let your winners run without going against your trading plan, or leaving yourself to the hope of “it will come back”.
The real difference between trading and investing is in the way of looking at assets. For a trader every financial market is an opportunity; although lot of traders specialize in certain markets, the principles of trading can be applied to every traded asset. For example, the Japanese candlestick method, which is widely used in stock trading even today, was developed by rice traders several hundreds of years ago.
An investor, on the other hand, has to be familiar with the assets fundamentals, the business behind a stock, the supply-demand balance of a commodity, the macro situation of a currency and so on… Otherwise, calculating the value of a given asset is not possible.
This primary difference leads to the stark contrast between the methods of the two approaches. While a trader might analyze the price chart, the order book, market statistics, and various indicators, an investor will look for clues in the financial statements of a company, the structure of a countries economy, demographic trends, and countless other fundamental measures.
In this debate, those who are new to the world of financial markets and investments, have a distinctive advantage. What is that? Well, of course, it is the ability to realize that ignoring trading as an investor or investing as a trader has no point.
Who would deny that buying a cheap company that will provide dividends for the next 20 years is a great thing? Also, who would say that a high probability technical entry point that could lead to lofty gains in a matter of days is a bad opportunity? The answer to both questions is easy—those who already built up a bias towards one of the approaches. Don’t be among them, and use both trading and investing to reach your financial goals.
Some of the most successful investors (or traders) use some sort of a mix of the two analysis methods. It makes sense too, knowing the fundamental pressures of a given market could boost your trading returns, while timing your entry into a promising investment position might provide significant extra gains to you.
Keep an Open Mind but Always Know What You Are Doing
The takeaway is that as you progress as both a trader and an investor, you should be able to harvest the skill sets of both approaches without having to choose between them. That said, there are certain dangers of applying different sets of rules at the same time.
Mixing up trading and investing in a given position often leads to heavy losses. For example, if you enter a position with a trading setup, with a given stop-loss level and the asset moves against you, removing your stop-loss order “Because it will be a good investment!!” is simply rationalizing a move against your trading plan. Don’t give us wrong, you might get lucky, but odds are that you will end up with losses in the long-run because of these decisions.
On the other hand, there is nothing wrong with letting a winning trading position run, maybe after exiting a part of the original position, if it’s in line with your investment plan (think position sizing and portfolio weights). That, of course, implies that you did your homework regarding the asset as an investor before you started trading.
We will revisit this very lucrative opportunity (among many others) when we dive deep into investment strategies, but for now just remember that with conscious planning and good execution, the two approaches can easily work hand-in-hand, helping you in boosting your returns and significantly reducing your downside risks.
A Final Word on Passive Investing
These days, after 8-years of blatant central bank intervention, the financial world is all about the success of passive investments, which are often confused with value investing. This couldn’t be further from the truth. Passive investment is something totally different, as it means that you simply follow the market rather than choosing the most promising assets.
If you truly want to hack the system you have to look past the temporary supremacy of passive strategies, as it can pass without any warning. Taking the decisions in your hand and learning to use just the right trading and investment tools will help you succeed in any environment.
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